The basic concept of the futures market is that the fluctuations in the price of a commodity are prevented by agreeing to pay a certain fixed price for the commodity when it will be delivered in the future. This practice dates back to Greek and Roman marketplaces. Whether it was the supply of grains from North Africa and Egypt to fulfill the ever growing needs of ancient Rome or other goods brought from different corners of the Roman Empire. The basic problems and situations faced by the traders and merchants at the Agora in Athens and Forum in Rome (which were major commercial centers besides being cultural centers) were very similar to the current problems. There was a need to manage price and the delivery risk, need for transparent and timely market and price information. Contracts were used by individual traders to fix the price of commodities to be delivered in future...to manage their risk and ensure smooth operations.
The first formalized futures exchange market is generally accepted to be Dojima Rice Exchange in Japan formed in the 1730s. Early the forward contracts would be signed between individual traders. However the basic problem was about trust within the entire system. If the price increased substantially the seller would have a great incentive to sell the commodity in open market rather than to the person with whom the contract is signed at a lower fixed price. Similarly if the price dropped substantially it would be better for the buyer to purchase the commodity from the open market rather than meeting the terms of the contract and purchasing the commodity at a higher fixed price from the seller. There was no third party which could ensure that the terms of the contracts are fulfilled by both the parties.
Chicago emerged as one of the major centers for grain farmers in the 1840s. However during good harvest season the price would drop substantially and during bad harvest season the price would become astronomically high. For this purpose Chicago Board of Trade (CBOT) was formed where the first forward contract was written on 13th March 1851. By 1865 the CBOT introduced futures contract for a range of commodities including Wheat, Corn and Oats. These contracts would specify the quantity and quality of commodities to be delivered and let the price to be decided by the market. This helped in knowing the actual produce coming into the market from thousands of individual farmers at different time in the year. Also it helped in developing storage silos where the commodity could be safely stored and sold at a later date. This prevented the wild fluctuations in price which were seen earlier.
By 1898 other goods were included for which futures were traded such as eggs, butter, potatoes, onion and hides (Chicago Butter and Egg Board). It changed its name to Chicago Mercantile Exchange (CME) in 1919. Slowly more products were added and by 1970s financial and currency futures were added, interest rate products added in 1981 and options and equity index futures in 1980s. One of the major reasons for the popularity in these products during the last quarter of the twentieth century is the breakdown of Bretton Woods exchange rate mechanism and development of a free market mechanism to discover exchange rate values. This exposed the manufacturers and consumers to fluctuations in the exchange rate. Hedging became important to ensure smooth operations and hence the futures market provided an appropriate mechanism to share risk and return.
Fig: Massive Wheat Trading Pit built in the CBOT building at the height of Great depression in 1930. Concentric sitting places allowed easy auctioning and trading.
There was simultaneous growth of similar market in other areas. In 1850s the first forward contract was traded in New York. By 1870 there were standardized futures contract on the New York Cotton Exchange. By 1882 the New Orleans Cotton Exchange started formalizing futures contract. Similar developments were seen elsewhere in London, Amsterdam, Brussels, and more. With the advent of internet and better technologies electronic trading has become much more common. CME launched the CME Globex electronic trading platform. The EUREX exchange was formed in 1998 when the German derivatives exchange Deutsche Terminborse (DTB) and the Swiss Options and Financial Futures Exchange (SOFFEX) merged. It was also the first exchange which offered only electronic trading and removed pit trading completely.
Globally there are more than 100 exchanges which range from behemoths like the CME Group to the much more modest Sibex exchange in Romania and Mercantile Exchange of Madagascar. The futures contract may have got its start with agricultural products however now more than 80% of the contracts traded are financial contracts. Also majority of trades are accomplished through the electronic platform and exchanges like EUREX have completely shifted to electronic platform.
Besides the stellar growth there have been a number of objections to futures trading in the past (and even today). The basic premise is that it is nothing more than glorified gambling and many object to it on a moral ground. Gambling is dependent primarily on luck and the odds are always stacked against the player. However in futures trading there is huge amount of research, data analysis, planning, trading and management discipline and much more. The futures market is considered to be a "zero sum game" - which means that one persons gain is exactly equal to another person's losses (excluding transaction costs). It provides opportunity to manufacturers and consumers who want to protect themselves from price fluctuation and external factors and it gives an opportunity to speculators who have done thorough research and planning to seek profits from their trades.
There have been continuous legislations against future trading. To name a few important one’s:
- California’s constitution invalidated futures trading in 1879 (it was later revoked in 1908)
- Failing to cover short sales within 5 days was considered a misdemeanor under Pennsylvania law in 1841 (repealed in 1862),
- Two major anti-futures trading legislation were passed in the late 1800s in both the houses of US Congress (they finally failed based on certain technicalities).
Whether it is the ancient marketplaces of Greek and Roman civilization or the current world of electronic trading the principle idea behind the futures trading is the same. It leads to better price discovery, protecting the merchants from unforeseen fluctuations, helps in smoothness of operations and at the same time provides opportunity to traders who have done thorough research to profit from their trades.
Introduction to the Futures Market Tutorial
1) Introduction to the Futures Market
2) History of the Futures Market
3) How the Futures Market Works
4) Difference between a Forward and Futures Contract
5) Participants in the Futures Market
6) Main factors that impact Futures Prices
7) What is a Futures Clearing House?
8) Risks in the Futures Market